Fear Factors

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We don’t place much faith in the collective wisdom of crowds. If large groups are so remarkably intelligent, why do half of New York City’s 2.9 million office workers go outside at 12:30 P.M. every day and wait in line to buy sandwiches?

Round up the right executives, though, and we can crack almost any nut — or at least extract some fresh perspective on the liquidity and credit problems facing financial markets and businesses.

That’s exactly what we did as the subprime crisis and its aftershocks roiled the markets in late summer. We interviewed a sextet of bankers individually about the disruption and what it may portend. The stereotypical banker is guarded to a fault. But when given free rein to comment on fear in the markets, hidden risks to corporations, and whether banks and companies will be better for the crisis, our commentators happily let loose.

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What about the state of the financial markets keeps you awake at night?

Douglas S. Roberts: The huge global nature of the financial markets and the balance required to maintain it. The credit crisis is being addressed by the [Federal Reserve], the European Central Bank, and the Bank of Japan. The Bank of England and the Chinese Central Bank are also probably involved. If this coordination falls apart, you could have a situation in which a foreign central bank is tightening and the Fed is loosening. Because of the global nature of the capital markets, the central banks operating in opposite directions could create a situation in which the effectiveness of Fed action would be negated.

Mark Sunshine: What keeps me awake is the failure of the Federal Reserve to recognize that its policy is, in part, responsible for the current market problems. In the late 1980s and 1990s, the FDIC and the Office of the Comptroller of the Currency recognized that subordinated securities in securitizations — collateralized loan obligations/collateralized debt obligations — were more like equity than debt and that banks and thrifts had to treat them that way. Unregulated entities became the primary investors in these securities and have increasingly used them as collateral for loans. The Fed could have used its regulatory power and increased the margin requirements on such securities. That would have forced firms to lend less against CLO/CDO bonds that have equity risks.

Mark Howard: I’m worried that the malaise in the subprime world is unfairly tarnishing the corporate world. That worries me because there are distinctly different credit dynamics in residential real estate than there are in corporate credit. You have seen a flight to quality or to safety that has the potential to unfairly tarnish or adversely affect other borrowers that don’t have any issues.

What are the biggest risks in the U.S. financial markets?

Mark Sunshine: Corporate finance chiefs need to worry about the financial health of their lenders. I believe that most don’t know how to manage the catastrophic effect of a lender failure. A large number of commercial lenders are very poor credits. They syndicate their loans to investors that are also poor credits, and [are therefore] at risk of not being able to continue funding. Several of the large nonbank commercial lenders and investors may not survive the market cycle, and as they fail, they will in turn cause their customers to fail.

Robert S. Bucklin: If you look at the syndicated-loan market in 2007, fully 65 percent of that came from the institutional market. Those guys have dramatically decreased [their participation]. They will probably come back when they get comfortable again, and when they know the full extent of the subprime issues. I don’t see [companies] getting boxed out of the market, but creditors are demanding more-traditional covenant structures, and leverage multiples are getting more conservative.

Don Wilson: This is fundamentally a long-overdue repricing of risk across the debt and financing markets — one that is unfortunately happening in a fairly sudden mannerÂ . [In response,] companies need to pay particular attention to their sources of liquidity and uses of available collateral. Businesses and transactions that may have been marginally viable in the recent past may no longer be viable when the risks they represent are more appropriately reflected in their cost of capital.

Are there other risks in the financial markets that might be lying in wait?

Don Wilson: While much of the media has focused on the buzzword of subprime in relation to the retail and consumer markets, there are similar issues in the corporate arena, in which the separation of high-quality debt and mezzanine and lower debt levels has become increasingly blurred. If markets overreact and go from underpricing risk to overpricing risk, there could be broader economic results, as even quality activity gets constrained by excessively expensive cost of capital.

Mark Howard: The slowdown in investor volumes has caused a lot of financial institutions’ balance sheets to get clogged up. Their capital is tied up in bridge loans or subprime commitments or other assets on the books that lack bids from interested buyers. How will they deal with that? The answer is, it depends on the type of asset. The way you deal with it is you ride out the storm and then you market more aggressively when the weather is better.

When the dust settles, will the markets and banks be in better shape than before?

Art Hogan III: Unfortunately, we have to feel a lot of pain before we make the system betterÂ . [Up until now] there has been an outsized reward for increased risk-taking, which worked fine. But as soon as we had volatility, the outsized reward for taking risk turned into outsized punishment.

Douglas S. Roberts: The markets and banks will definitely be in better shape, since this crisis is forcing governments and central banks to begin to address the inherent risks in the system and is pushing nonblank players to deleverage. It is like consulting a cardiologist when you experience chest pain instead of after you have had a heart attack.

Don Wilson: Unequivocally, yes, the financial markets and banks, in particular, will be better offÂ . The massive influx of liquidity into the credit markets during the last decade — all chasing incremental return during a period of relative economic stability — flattened the credit curve and funded deals that would not have otherwise been funded. This stifled the working of the “invisible hand” of the capitalist economy, and undoubtedly allowed marginal businesses to soak up valuable resources.

Contributors

Douglas S. Roberts is founder and chief investment strategist of ChannelCapitalResearch.com and a frequent poster on BloggingStocks.com.

Mark Sunshine is president and chief operating officer of First Capital, a provider of factoring and asset-based lending to middle-market companies.

Mark Howard is a managing director and co-head of research at Barclays Capital. His research team focuses on credit-risky asset classes, including asset-backed and convertible securities.

Robert S. Bucklin is head of corporate banking in North America for Rabobank International, a Dutch-owned bank. His group finances food and agricultural businesses in the United States and Canada.

Don Wilson is president and chief operating officer of Amcore Financial, a commercial bank operating in Illinois and Wisconsin. He was formerly the CFO.